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Tyson Foods Overvalued: Time to Consider Selling


An updated analysis explains why investors should be exiting.

In October of 2012 I recommended Tyson Foods (NYSE:TSN) at $16 as a buy, just as the company was facing a drought situation. Then I said, "In investment analysis (as well as in agri-business), the assumption is that there will be a return to normal. Therefore, Tyson should be bought, based on its normalized earnings potential and on the assumption that normality will return." Currently the opposite is true. But besides earnings and valuation being above a normalized level, the holders of the stock may well be pricing in a 1% decline in the traditional risk discount. Still, experience has taught that the stock market never prices in a lower risk discount for a cyclical stock before that company has weathered one of its traditional cycles with significantly less EPS cyclicality.

At the end of January 2013, I stated that Tyson was efficiently valued at $23, as some winter snows and the expectation of more ground moisture in the western corn belt was a positive. A Merrill Lynch analyst also then initiated a buy recommendation on the stock while using EPS estimates that were above normalized levels, and I felt good about a 35%+ appreciation in the stock.

The stock price continued upward, as the US corn crop started to look pretty decent. Additionally, the announced acquisition of Smithfield Foods (NYSE:SFD) by Shuanghui International and avian influenza (sanitation in production) in China focused investors on opportunities in pork and chicken in China over the longer term. Some spillover from the rally in branded consumer staples stocks was another plus.

Tyson has told investors that it has made changes to insulate itself from some cyclicality going forward. True, as maybe 35% of its contracts allow a raising of prices when grain costs rise. An approximate three-month lag here is about as closely as earnings can be smoothed. Good. And there is hedging. There is also some change in the business mix from movement into prepared foods, but Tyson is a large company and its business mix cannot change quickly. Look across the CPG food companies and you see nothing but declines in returns, so while Tyson's profitability will increase with more prepared foods, it is no panacea to a higher stock price soon.

Finally, more than half of the US chicken industry is still in private hands of producers who will not be doing anything special to cut the industry's traditional cyclicality now. Overproduction is an almost sure bet to return, in 2015, if not 2014. And that overproduction will drive the stock price well below fair value.

Among others, I have seen Kimberly Clark (NYSE:KMB) and Newell (NYSE:NWL) not get credit for decreased earnings cyclicality on a prospective basis, even when the progress was pretty obvious. I cannot believe that Tyson will be any different. I do believe that an undeserved 7% risk discount has now gotten to about 6.5%, and faster than I would have expected. Further, I believe that it may well be prudent to assign a smaller 6% risk discount to the stock price target after Tyson stock gets to the bottom of its next chicken industry overproduction cycle. But the market has presently gone overboard on a mix of long-term growth, normalized EPS, and/or an expectation of reduced cyclicality now.

Updating normalized earnings from my original buy recommendation for two years at a 5% growth rate results in a $2.13-$3.03 normalized EPS range, based on management's previous estimates. But all three proteins are not going to be at the top end of their normalized ranges. So, I use a $2.58 EPS number to focus on for 2014.

To value the stock I use a standard MBA school three-stage EPS growth model. My risk-free rate is the long Treasury plus 50 bps to counter the now declining quantitative easing by the Fed, equaling 4.2%. I have cut my risk premium assigned to Tyson from 7.0% (which was never really justified by operational or financial risk, but only by incorrect market perception) to 6.5% because of developments in China over the past 18 months, some reduced earnings cyclicality, and continuing investor disappointment with CPG company growth expectations that I believe are leading to a more rational attitude toward Tyson, something I expected to evolve over the longer term, but not over the past six quarters.

Using a 1.5% terminal growth rate for EPS, Tyson at $39 per share, using my normalized EPS estimates of $2.58 and $2.71 for 2014 and 2015, discounts an 9% five-year growth rate, higher than the Street consensus of 7% and the 4-5% (world protein consumption growth plus some slow margin increase and market share growth) that I believe is reasonable. Alternately, using a Street consensus estimate of $2.88 for FY14 and $3.05 for FY15, the stock discounts the Street consensus 7% growth rate. The last alternative, a 6% risk discount on my normalized EPS numbers, discounts a too high 8% growth rate.

The bottom line is that the time to exit is at fair valuation, and valuation has gone beyond that level. A 5% five-year growth rate on a $2.58 base implies a $32 price using a 6.5% risk discount. Sell the stock.
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No positions in stocks mentioned.
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